Spain's pain could be European Union's demise

Liam Halligan

FRENCH President Nicolas Sarkozy five weeks ago declared: ''Today the problem is solved. How happy I am a solution to the Greek crisis, which has weighed on the economic and financial situation in Europe and the world for months, has been found.''

Just when you hoped it really was ''solved'', the eurozone crisis has roared back. The fundamental contradictions at the heart of monetary union refuse to go away. The busted banks, the grotesque indebtedness, the inherent denials have all burst back into view.

The eurozone has deeply entrenched economic, financial and political problems. No amount of tub-thumping can change that truth. The focus now is on Spain. Will Spanish debt woes spiral out of control and, if so, can they then be contained? That's the €1 trillion question.

Spain is the fourth-largest eurozone economy and the 12th biggest in the world. Spanish GDP last year was almost five times that of Greece. On the surface, Spain's government finances don't look bad, with national debt at 68 per cent of annual GDP - about half that of Italy.

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But Spain has vast and less widely recognised private sector debt. Global bond markets, previously sedated by ECB ''funny money'', now realise that a big slice of these liabilities could land on the government's balance sheet.

In the 1990s, in the run-up to monetary union, the Spanish government ''deleveraged'', cutting back debt to comply with the unfortunately-named Stability and Growth Pact. A national determination to maintain Spain's massive construction boom led to an increasing reliance on private sector debt instead.

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As eurozone membership approached, Spain's household debt tripled. Spanish companies gorged themselves and are now servicing six times more debt relative to output than their German counterparts and twice as much as companies in the United States. The result is that total private sector debt in Spain is almost 300 per cent of annual GDP. With property prices 30-40 per cent down on their 2007 peak, swaths of non-performing loans lurk on the balance sheets of Spain's savings banks.

Spanish sovereign debt is relatively low. So was Ireland's before Dublin was forced to find vast sums, despite some pretty brutal restructuring, to prop up the country's bloated banks.

The Irish decided to stand behind their banks. Spain won't, but to prevent a wave of bank-busting defaults and untold social unrest, a lot of Spanish private debt, sooner or later, will be ''socialised''.

That will mean a new wave of spending cuts. But before that happens, Spain is hurting badly. Unemployment hit a record 24 per cent last month, the highest in the industrialised world.

In a bid to boost employment, Prime Minister Mariano Rajoy's government passed new laws making it easier to cut wages and lay people off. The Spanish unions responded with a general strike, which became a national demonstration.

Before the upcoming European Central Bank summit in Barcelona, some protesters have been kept ''in detention'', accused of plotting further ''anti-system activities''. A few Franco-era laws remain on Spain's statute book and the deeply-paranoid authorities are using them. Spain's situation is grave indeed.

On top of that, last week we learnt that Spain has tipped back into recession. Ministers admit public debt will hit 80 per cent of GDP by year-end. That's before any systemic panic, which would see droves of private debtors throw themselves on to the state.

Was there ever a more stark illustration that monetary union doesn't work and cannot work unless member states agree to merge their bank accounts? There is little chance of that.

The spectre of another eurozone bail-out looms. Spain must repay a €11.9 billion bond on April 30, and another €12.8 billion at the end of July. If investors refuse to finance this repayment at an ''affordable'' rate, what happens next?

Under Rajoy, Spain has been trying to get its finances in order. Faced with public disorder, his government has clamped down hard. But to appease the domestic mob, Rajoy has been thumbing his nose at the eurocrats. Leading Dutch politicians now say they should quit the euro. It can't be long before this view is ''acceptable'' in Germany, too.